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Many commentators Fisher Investments Canada follows claim valuations – calculations of equities’ current or projected worth – tell investors when to buy or sell a company. The conventional thinking is that high valuations suggest an equity is overpriced (hence, an indication to sell), whilst low valuations signal an equity is trading at a discount (hence, an indication to buy).

However, in Fisher Investments Canada’s view, valuations alone don’t reveal if equities are inherently cheap or expensive. We think investors likely benefit more from considering valuations in concert with equities’ underlying fundamentals.

Valuations aim to show a company’s worth, but methodologies vary. The price-to-earnings ratio (P/E) is one frequently cited valuation metric amongst market analysts we follow. P/E is calculated by dividing a company’s share price by its earnings per share – and the denominator can reflect trailing or forward earnings. Trailing P/E uses prior-year earnings, whilst forward P/E uses projected future earnings.

Another commonly used valuation method is the price-to-sales ratio (P/S), which is a company’s share price divided by sales per share over the past 12 months. Fisher Investments founder, executive chairman and co-chief investment officer, Ken Fisher, pioneered the P/S ratio and popularised it in his 1984 book, Super Stocks.

Valuations have their uses, but in Fisher Investments Canada’s view, using valuations alone to make investing decisions can be a mistake because they are generally pre-priced (already incorporated into share prices). Indeed, the equity price itself is an ingredient in valuations, yet past performance doesn’t predict future returns. Beyond that, we think equities are efficient discounters of all widely known information – meaning equity prices reflect broadly discussed data and popular opinions near-immediately – and valuation methodologies and their underlying data are well known.

For example, many valuations, like the trailing P/E, use a company’s past results in the calculation’s denominator. These data are public information and, in our view, a company’s past performance doesn’t reveal anything about its future direction. Forward-looking valuations, like the forward P/E, are based on analysts’ consensus estimates of a company’s future earnings. In our view, these valuations are also limited, for no matter how well-researched or thoroughly analyzed the data may be, the future is unknowable. Plus, expectations surrounding upcoming earnings are often widely discussed, making them likely also to be reflected in current prices.

Popular presumptions about valuations are also well known, further sapping their potential use. Take P/S: Whilst it may have provided an edge when it was relatively unknown several decades ago, P/S eventually became widely discussed in financial publications – and has even been a part of some financial certification curricula. In our view, this widespread use caused it to become priced in; by the time one identifies a potentially undervalued equity using the P/S ratio, others have quite likely made the same discovery and traded on it. The surprise power will generally be gone.

Fisher Investments Canada thinks investors may benefit more by considering valuations in the context of equities’ underlying fundamentals. For example, equities trading above or below the MSCI World Index’s 12-month trailing P/E may look expensive or cheap. But our research has found that growth-orientated companies (firms whose earnings growth comes from expansion and capitalizing on innovation and long-term trends) tend to trade at above-average valuations since investors are often willing to pay more for their long-term potential.¹

In contrast, value-orientated companies (those with relatively lower prices compared to their underlying assets and earnings potential) tend to have below-average valuations.² Therefore, a growth company (e.g. a large tech multinational) with a high valuation relative to the broader market may not necessarily be an outlier whilst a value firm (e.g. a regional bank) with the same valuation could be. Since equity style leadership rotates – i.e. sometimes growth outperforms whilst other times value is in favour – being aware of these distinctions is worthwhile for investors, in our view, as valuations that appear to be outliers may not be so.

However, even valuation outliers within a given sector aren’t necessarily surefire winners or losers. For example, if hypothetical Company X is much cheaper than its peers, we have seen experts argue that it is an indicator to buy based on mean reversion (the theory that prices will revert to their long-term average). Or, if an equity is more expensive relative to other shares in the same sector, it might seem like a good idea to sell.

But our research shows supposedly cheap equities can get cheaper and expensive equities can become more expensive. We think it is important to analyse the individual company. What if Company X’s shares are cheap for a reason? Perhaps it faces major headwinds, e.g. corporate governance issues or regulatory uncertainty. Similarly, a company that appears expensive may justify a higher valuation because of a strong competitive advantage – and it may still be worth owning, going forward.

In Fisher Investments Canada’s view, valuations alone don’t reveal if an equity is set to fall or rise – and aren’t necessarily beneficial to investors when making buying or selling decisions. Fundamentals are key, in our view.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments Canada and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments Canada will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

Fisher Investments Management, LLC does business under this name in Ontario and Newfoundland & Labrador. In all other provinces, Fisher Asset Management, LLC does business as Fisher Investments Canada and as Fisher Investments.

¹ Source: FactSet, as of 08/04/2022. Statement based on trailing P/E of MSCI World Index and MSCI World Index Growth.

² Ibid. Statement based on trailing P/E of MSCI World Index and MSCI World Index Value.

This content was produced by Fisher Investments Canada. The Globe and Mail was not involved in its creation.